What is a Quality Small Cap Company?
Quality small cap companies are generally well-managed businesses with reasonable growth outlooks and the financial strength to be investable over the intermediate term.
The following three characteristics are common with high-quality stocks that demonstrate greater consistency and lower downside risk over multiple market cycles:
In the new economy, analyzing return on invested capital (ROIC) and cash flow generation can be a better way to value a company’s intellectual capital and ability to generate profits from assets. Consequently, GAAP earnings can distort the “true economic” profitability of a company making traditional valuation methods such as Price to Book (P/B) misleading.
Strong balance sheets, including the appropriate leverage ratios and ability to service debt throughout the investment cycle and cyclicality of cash flows.
Understanding how management is allocating capital to expand its business, including their ability to use equity and debt, is essential.
A company’s ability to maintain its advantage in order to protect long-term profits and market share from competing firms is critical. This is most important for maintaining strong fundamentals related to sustainable and predictable growth, stability of cash flows, earnings and capital expenditures.
Why Invest in Quality Small Caps Today?
Figure 1: Factor Performance During Periods of Distress
Factor Performance Following 10-Year Treasury / 2-Year Treasury Yield Curve Inversion
(U.S. SmallCap Universe)
Figure 2: Sample Factor Performance Across the Economic Cycle